Credit Derivatives

By:Harshil Pacheria Priyanka Kaul

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Definition
A credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" of the underlying loan. It is a securitized derivative whereby the credit risk is transferred to an entity other than the lender.

 Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
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 This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.
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History and Participants

The market in credit derivatives started from nothing in 1993. By 1996 there was around $40 billion of outstanding transactions, half of which involved the debts of developing countries. Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations.
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 The ISDA reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). As reported in The Times on September 15, 2008, the "Worldwide credit derivatives market is valued at $62 trillion".

 Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%. The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates.

Types
Credit derivatives are fundamentally divided into two categories: Funded credit derivatives, and Unfunded credit derivatives

Unfunded Credit Derivative

An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets.

Unfunded Credit Derivative

Unfunded credit derivative products include the following products: Credit default swap (CDS) Total return swap Constant maturity credit default swap (CMCDS) First to Default Credit Default Swap Portfolio Credit Default Swap Secured Loan Credit Default Swap Credit Default Swap on Asset Backed Securities Credit default swaption Recovery lock transaction Credit Spread Option CDS index products

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Credit default swap: The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market. The product has many variations, including where there is a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities. Total return swap: Total return swap, or TRS (especially in Europe), or total rate of return swap, or TRORS, or Cash Settled Equity Swap is a financial contract that transfers both the credit risk and market risk of an 11 underlying asset.

Key unfunded credit derivative products

Funded credit derivatives

Funded credit derivative products include the following products: Credit linked note (CLN) Synthetic Collateralized Debt Obligation (CDO) Constant Proportion Debt Obligation (CPDO) Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

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Key funded credit derivative products

Credit linked notes A credit linked note is a note whose cash flow depends upon an event, which may be a default, change in credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note. A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its note like features, a CLN is an on-balance-sheet asset, in contrast to a CDS. The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.

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There are several different types of securitized product, which have a credit dimension. Credit-linked notes CLN: Credit-linked note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be. Collateralized debt obligation CDO: Generic term for a bond issued against a mixed pool of assets - There also exists CDO-squared (CDO^2) where the underlying assets are CDO tranches. Collateralized bond obligations CBO: Bond issued against a pool of bond assets or other securities. It is referred to in a generic sense as a CDO Collateralized loan obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO
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Collateralized debt obligations (CDO)

Collateralized debt obligations (CDOs) are a type of structured assetbacked security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDO securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

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Pricing
Pricing of credit derivative is not an easy process. This is because: The complexity in monitoring the market price of the underlying credit obligation. Understanding the creditworthiness of a debtor is often a cumbersome task as it is not easily quantifiable. The incidence of default is not a frequent phenomenon and makes it difficult for the investors to find the empirical data of a solvent company with respect to default. Even though one can take help of different ratings published by ranking agencies but often these ratings will 16 be different.

Risk
Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. Incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.
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Thank you
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